Executive Compensation & Corporate Governance

Transcription

1 Executive Compensation & Corporate Governance A survey examining compensation in SMI, SMIM and small-cap companies as well as trends in corporate governance Insights 2014

2 Disclaimer This publication has been prepared for general guidance on matters of interest only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy or completeness of the information contained in this publication, and, to the extent permitted by law, PricewaterhouseCoopers Ltd., its members, employees and agents accept no liability and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.

3 Contents 1 The Study 2 2 Executive Summary 3 3 Top Management Compensation: Main Results Chairmen of boards of directors Other members of the board of directors CEOs Structure of compensation Wealth changes due to share ownership Small-cap companies 16 4 Executive Compensation and Corporate Governance after the Abzocker-Initiative : Challenges and Opportunities Pay for performance Challenges in the design of compensation systems Challenges for compensation governance and for the board of directors 24 5 Concluding Remarks: Six Principles 27 PwC Executive Compensation & Corporate Governance 1

4 1 The Study We are delighted to present the eighth edition of our study Executive Compensation & Corporate Governance. This study is one of the most detailed Swiss studies available on the level and structure of board and executive compensation for the years from 2007 to This report provides a comprehensive picture of executive compensation for SMI and SMIM companies in Switzerland today. We also provide a shorter summary of executive compensation in small-cap companies, and we hope you find this breadth of perspective helpful. Following the release of the Ordinance against excessive compensation in stock exchange listed companies, many, but by far not all listed companies revised their articles of association in the 2014 proxy season. This includes in particular choices with regard to the say-on-pay regime but also several other aspects of corporate governance. The main observation that can be made from companies responses to the new regulatory setting is that one practice does not fit all. Boards of directors, executive management as well as investors in particular institutional investors such as pension funds have the responsibility to consider what is the appropriate design and disclosure of compensation matters in the specific context of a given company. An ongoing dialogue between boards of directors, investors, and other stakeholders is essential for fostering the long-term positive development of companies. All data used in this survey is based on disclosed compensation information in the annual reports of the companies reviewed. We have not made any assumptions or adjustments to the disclosed values and methodologies used, in particular with regard to the variable compensation (valuation, vesting clauses, timing of disclosure and earning periods, etc.). We trust you find Executive Compensation and Corporate Governance: Insights 2014 to be an interesting read that supports you in answering key questions and provides ideas for addressing today s reward challenges. As always, we welcome your feedback and hope to have the opportunity to discuss these issues with you. Dr. Robert W. Kuipers Partner Remo Schmid Partner 2 Executive Compensation & Corporate Governance PwC

5 2 Executive Summary Building on the results from the studies of the last six years, Executive Compensation & Corporate Governance: Insights 2014 examines the changes from 2007 to 2013 in total compensation for the board of directors and CEOs as well as some governance topics. The key findings are: In the seven years under consideration, median non-executive chairman pay has increased in both SMI and SMIM companies: by 16.2 % from slightly below CHF 1 million to slightly above CHF 1.1 million in SMI companies and by 41.6 % from CHF 384,327 to CHF 544,000 in SMIM companies. However, last year, chairman pay in SMIM companies declined by 7.9 %. By contrast, in the same period, median CEO pay has decreased in SMI companies by 17.6 % from CHF 8.1 million to CHF 6.7 million. Interestingly, though, CEO pay in SMIM companies increased due to a strong increase in 2013 from 2007 to 2014 by 12.4 % from CHF 2.8 million to CHF 3.2 million. This outcome is partially driven by an unusually large number of CEO turnovers and the corresponding additional payments to incoming CEOs. The composition of CEO pay fluctuates significantly, but some broad patterns can be detected. In SMI companies, base salary has never made up more than 30 % of total pay, long-term incentives (LTI) never less than 40 % (and they are close to or exceed 50 % in some years). In SMIM companies, by contrast, throughout the sample period (except in 2007), base salary did not make up less than 30 % of total pay, while the LTI did not account for more than 40 % of total pay (and falls below 30 % in some years). Cash bonuses and other payments are of approximately equal importance in the two samples. The median board member at a small-cap firm receives pay of around CHF 100,000, and this pay level has essentially remained stable in the past seven years. The median CEO of a small-cap company received roughly CHF 1.2 million in As such, median CEO compensation in these firms is now slightly above 2007 levels. Small-cap CEOs tend to receive a larger portion of base salary and a smaller portion of equity-based compensation than their counterparts in SMI and SMIM companies. Pay of small-cap CEOs is less volatile over time than is pay of SMIM CEOs, which is in turn more stable than pay of SMI CEOs. Executives and board members participated with their equity holdings in the continued general positive stock market developments in In the SMI and SMIM sample, more than 75 % of all CEOs experienced positive wealth changes, with the interquartile range (between lower and upper quartile) being CHF +540,000 to CHF +2.2 million. For chairmen, this range is from CHF +180,000 to CHF +1.4 million for For other board members, this range amounts to CHF +30,000 to CHF +400,000 for A similar picture also emerges in the small-cap companies. Our rich dataset allows us to identify five different channels of pay for performance. First, the ratio of executive total compensation to earnings before interest, tax, depreciation and amortisation (EBITDA) is approximately constant over time. This means that, in aggregate, when profits vary, total top management pay varies in the same direction. Second, when total shareholder return increases by one percentage point, variable CEO pay increases by about 1.2 %. (We note that variable pay is difficult to measure precisely as companies vary in their approaches for disclosing long-term incentive components in particular.) Similarly, return on equity is significantly associated with variable pay. Return on assets, by contrast, is not associated with variable pay, suggesting that companies, on average, are not explicitly rewarding operating performance. Third, the typical CEO in an SMI firm receives pay which is three times higher than the average non-ceo executive. In SMIM and small-cap firms, the typical CEO receives double the pay of non-ceo executives. This induces a fairly strong set of what economists call tournament incentives within companies. Fourth, the median CEO of an SMI company earns twice the remuneration that the median CEO of an SMIM company earns, and the median CEO of an SMIM company receives 2.6 times the pay that the median small-cap CEO obtains. Given this strong relationship between pay and firm size, we conclude that there can be substantial (implicit) incentives for executives and board members of Swiss companies driven by the fact that career advances depend on success at the present company. Fifth, SMI, SMIM, and small-cap CEOs participate in shareholder wealth creation (and reduction) due to their equity holdings. A change in shareholder wealth of CHF 1,000 is associated with a change in CEO wealth of CHF 0.2, CHF 0.6, and CHF 1 for the median CEO in each of these groups of firms, respectively. PwC Executive Compensation & Corporate Governance 3

6 Based on our analysis of the pay-performance relationship, we discuss several questions around pay design. Compensation should achieve the goals of incentivising management properly as well as attracting and retaining the best-suited managers. We argue that suitable key performance indicators should align managerial behaviour with firm value, are effective when management can actually influence performance, and reflect the reality that teamwork is essential for most firms success. We also show that these goals are often in conflict with each other. Perhaps counterintuitively, we argue that variable compensation should not completely filter out all exogenous factors, that is, it should not only depend on the achievements of the CEO relative to other companies but should also have an absolute performance component. Finally, caps on variable pay offer some advantages, but need to be handled with great care. In this publication, we also analyse and discuss how companies have responded to the Abzocker-Initiative by adjusting their articles of association. Several interesting empirical observations arise. For example, companies that chose a prospective voting regime without a retrospective advisory vote tend to have much lower median CEO compensation than those who chose a retrospective voting regime. The latter group in turn has lower median CEO compensation than those companies which chose a prospective voting regime with a retrospective advisory vote. We conclude by stating some implications for the next proxy season, in particular as regards the role of the board of directors. We argue that open dialogue, pro-active communication, and stakeholder engagement are essential for fostering the long-term positive development of companies. The board of directors should not be afraid to engage with major shareholders and should be aware of the key differences in policies and processes of proxy advisors such as Ethos, ISS, Swipra, and zrating. 4 Executive Compensation & Corporate Governance PwC

7 3 Top Management Compensation: Main Results In this section, we analyse and comment on the level and structure of compensation for chairmen of boards of directors, other board members and CEOs. Our focus is on SMI and SMIM companies (sections 3.1 to 3.5), but we also provide a summary perspective on small-cap companies (section 3.6). 3.1 Chairmen of boards of directors As the structure of the board of directors and the related responsibilities and tasks for members of the board of directors vary, for the chairman in particular, a one-to-one comparison among the SMI and SMIM companies proved difficult. Nevertheless, a comparison was made based on compensation data disclosed. Some companies disclose separately pay that a chairman/ceo receives in his two roles. In this case, we include the corresponding individual with the chairman pay in this section and with the CEO pay in the CEO-related analysis. When pay is not shown separately for the two roles, this individual is considered only in the CEO analysis. We also do not include chairmen who held a non-ceo executive role in this analysis, unless pay for the executive function is separately disclosed Main findings In the seven years under consideration, median chairman pay has increased in both SMI and SMIM companies from CHF 981,479 to CHF 1.1 million, or by 16.2 %, in SMI companies and from CHF 384,327 to CHF 544,000, or by 41.6 %, in SMIM companies. However, last year, chairman pay in SMIM companies decreased by 7.9 %. Figure 1: Total compensation of chairmen in SMI companies 1) Million CHF Lowest Lower quartile Median Upper quartile Highest 1) Compensation for non-executive function (n=18 in 2013) PwC Executive Compensation & Corporate Governance 5

8 3.1.2 Details on SMI companies From 2012 to 2013, the median chairman compensation remained essentially constant at CHF 1.1 million. The upper quartile decreased by 11.6 % to CHF 4.2 million, whereas the lower quartile increased slightly by 1.4 % to CHF 620,260. Dispersion continued to decrease at the extremes: from 2012 to 2013, the compensation of the highest paid chairman decreased by 32.8 % to CHF 8.8 million whereas the compensation of the lowest paid chairman increased minimally by 0.6 % to CHF 200, Details on SMIM companies SMIM chairmen saw pay increases throughout, with the largest increase concentrated at the lower end: the lower quartile increased by 23.9 % to CHF 379,000 comparing 2013 with Increases were smaller at the upper end: the upper quartile increased by 9.6 % to CHF 920,417, and the highest paid received CHF 1.7 million, which represents an increase of 4.3 % from the previous year. However, the distribution between the lower and upper quartiles shifted such that, in fact, the median decreased by 7.9 % to CHF 544,000 last year, though it is still more than 40 % above the level of Figure 2: Total compensation of chairmen in SMIM companies 2) Million CHF Lowest Lower quartile Median Upper quartile Highest 2) Compensation for non-executive function (n=21 in 2013) 6 Executive Compensation & Corporate Governance PwC

9 3.2 Other members of the board of directors Main findings In 2013, the median board member of an SMI company received around CHF 320,000, approximately 60 % more than the median board member of an SMIM company, who received around CHF 200,000. As such, there has been some convergence between the groups, as in 2007 the median board member of an SMI company received around 75 % more than the median board member of an SMIM company. Compensation levels of SMI board members have been increasing slightly in a relatively small band from 2007 to For SMIM members, the increase has been somewhat more pronounced Details on SMI companies The lower quartile amounted to CHF 228,806 and the upper quartile to CHF 400,951 with small changes compared to last year, namely, increases of 5.4 % and 0.9 %, respectively. The median amounted to CHF 318,411 (a decrease of 2.4 % from last year). The highest paid amount has varied a lot over the years. In 2013, it remained similar to last year, with a small increase of 6 % to CHF 2.7 million. The median increased from CHF 297,059 in 2007 to CHF 318,411 in 2013 (+7.2 %). Figure 3: Total compensation of other members of the board of directors in SMI companies 3) Million CHF Lowest Lower quartile Median Upper quartile Highest 3) Chairman and executive functions excluded (n=188 in 2013) PwC Executive Compensation & Corporate Governance 7

10 3.2.3 Details on SMIM companies The lower quartile amounts to CHF 145,000 (+13.9 % relative to 2012) and the upper quartile to CHF 248,375 (+1.4 %), i.e., half of all SMIM board members were paid in this range for the year The median increased from CHF 169,500 in 2007 to CHF 194,955 in 2013 (+10.7 %), with the greatest increase taking place from 2012 to Figure 4: Total compensation of other members of the board of directors in SMIM companies 4) Million CHF Lowest Lower quartile Median Upper quartile Highest 4) Chairman and executive functions excluded (n=188 in 2013) 8 Executive Compensation & Corporate Governance PwC

11 3.3 CEOs Main findings Two facts are particularly noteworthy. First, from 2007 to 2012, total CEO compensation in SMI and SMIM companies had changed in parallel and decreased overall in both groups of companies; 2013 shows a marked difference between SMI and SMIM companies. Specifically, comparing 2013 to 2012, the median compensation of SMI CEOs remained essentially unchanged at CHF 6.7 million. Over the full sample period from 2007 to 2013, therefore, median CEO total compensation in SMI companies fell from CHF 8.1 million to CHF 6.7 million, or by 17.6 %. By contrast, due to a large increase in median CEO total compensation in SMIM companies from 2012 to 2013 (+33.8 %), over the whole period median total CEO compensation in these companies in fact increased from CHF 2.8 million in 2007 to CHF 3.2 million (+12.4 %). This finding should not be overinterpreted, though, as we discuss below. Second, as can also be observed from Figures 5 and 6, CEO compensation in SMI companies has in general varied significantly more over time than CEO compensation in SMIM companies. The development from 2012 to 2013 is the exception. It will be interesting to see whether this year remains an outlier. Figure 5: Total compensation of CEOs in SMI companies 5) Million CHF Lowest Lower quartile Median Upper quartile Highest 5) (n=20 in 2013) In 2013, there was only one (in 2012: one) company in which a member of the executive board other than the CEO received the highest total compensation. In 2008 and 2010, the highest paid disclosed person in the whole sample was not a CEO. In these firms the compensation of the CEO was not disclosed and so could not be used in Figure 5. Departing CEOs are not included in this calculation. PwC Executive Compensation & Corporate Governance 9

12 3.3.2 Details on SMI companies Comparing 2013 to 2012, the median compensation of SMI CEOs remained essentially unchanged at CHF 6.7 million. There was a slight divergence in the lower and upper quartiles: The upper quartile increased by 7.8 % to CHF 10.0 million and the lower quartile actually decreased further to CHF 4.5 million ( 5.9 %). The average total compensation increased slightly by 0.9 % to CHF 7.2 million. As such, the average total compensation is still significantly below the figures for 2007 (CHF 9.5 million, 23.9 %) when this survey was conducted for the first time (see also Figure 7) Details on SMIM companies In contrast to SMI companies, median total CEO compensation increased significantly in SMIM companies in the past year: It jumped by 33.8 % to CHF 3.2 million. Several factors need to be borne in mind. First, despite a generally positive market development in 2012, median pay had in that year not increased in SMIM companies (in contrast to SMI companies). Thus, we are arguably seeing a partial catch-up to a development that happened earlier in SMI companies. Second, the composition of the SMIM has changed. Third, SMIM companies saw a higher number of CEO changes than usual, and newly appointed CEOs tend to have a larger pay package than their predecessors. In fact, essentially the whole distribution of CEO pay shifted up. The lower quartile increased by 30 % and now amounts to CHF 2.3 million. The upper quartile increased by 26.0 % to CHF 4.3 million. Consequently, 50 % of SMIM CEOs are paid in the range of CHF 2.3 million to CHF 4.3 million. Average total compensation also increased from 2012 to 2013, by 24.9 % to CHF 3.6 million. However, from an overall perspective, the average total compensation has decreased over time by 9.2 % from CHF 3.9 million in 2007 to CHF 3.6 million in 2013 (see also Figure 10). Figure 6: Total compensation of CEOs in SMIM companies 6) Million CHF Lowest Lower quartile Median Upper quartile Highest 6) CEOs (exclusive highest paids) (n=24 in 2013) 10 Executive Compensation & Corporate Governance PwC

13 3.4 Structure of compensation As in previous years, we have analysed the structure of the average total compensation as we believe this provides important insights in addition to the analysis of the level Comparing roles By and large, a similar picture emerges for SMI and SMIM companies when comparing the structure of compensation of different roles. On average, the largest part of total compensation for chairmen and other board members between 80 % and 90 % comes from fixed and other compensation. (Fixed compensation refers to the sum of compensation in cash and non-performance-related payments conveyed in the form of equity-based compensation.) By contrast, variable pay (either cash bonuses or equity-based long-term incentive plans) makes up the biggest portion between 50 % and 70 % of the total compensation package for CEOs and other executives. Figure 7: Overview of compensation structure in SMI companies in 2013 Chairman Other Members of the Board of Directors CEO Other Executives % 20% 40% 60% 80% 100% Fixed compensation Cash bonus Long-term incentives Other payments Figure 8: Overview of compensation structure in SMIM companies in 2013 Chairman Other Members of the Board of Directors CEO Other Executives % 20% 40% 60% 80% 100% Fixed compensation Cash bonus Long-term incentives Other payments PwC Executive Compensation & Corporate Governance 11

14 3.4.2 Comparing companies Some interesting patterns become apparent when comparing SMI and SMIM companies and when considering the development of the pay composition over time. First, for board members of SMI companies fixed compensation was again a more important component in 2013 (relative to total compensation) than in SMIM companies. Other board members receive 86.6 % (SMI) and 80.4 % (SMIM) as fixed compensation, and these numbers have remained stable in the past seven years. The average chairman receives around 80 % in fixed pay in SMI companies and around 88 % in fixed pay in SMIM companies. Second, for CEOs, in SMI companies, for 2013, the average total compensation was split into 25 % base salary, 18 % cash bonus, 47 % long-term incentives, and 10 % other compensation. In SMIM companies, for 2013, the average total compensation was split into 31 % as base salary, 26 % as cash bonus, 32 % as long-term incentives, and 11 % as other compensation. These numbers appear representative for the seven-year sample period, even though the composition of average CEO pay fluctuates to some extent over the years. In SMI companies, base salary has never made up more than 30 % of total pay, long-term incentive plans have never made up less than 40 % of total pay (and exceed 50 % in some years). In SMIM companies, by contrast, throughout the sample period (except in 2007), base salary has not made up less than 30 % of total pay, while long-term incentives did not account for more than 40 % of total pay (and fall below 30 % in some years). The cash bonus and other payments are of approximately equal importance in the two samples. Figure 9: Structure of average total compensation of CEOs in SMI companies % 8 5% 7 49% 16% 11% 10% 10% 8% Million CHF % 40% 14% 55% 14% 42% 23% 48% 18% 45% 21% 48% 18% % 30% 26% 24% 24% 24% 26% Base salary Cash bonus Long-term incentives Other payments Executive Compensation & Corporate Governance PwC

15 3.4.3 Details on year-on-year changes in the structure of CEO pay In 2013, for SMI companies, the average base salary amounted to CHF 1.8 million, decreasing from CHF 2.2 million in 2007, a fall of 21.4 %. The average cash bonus amounted to CHF 1.3 million in 2013, which is a decrease of 16.7 % compared to Total average cash compensation (base salary plus cash bonus) decreased by 4.8 % to CHF 3.1 million comparing 2013 to The average long-term incentives increased from CHF 3.2 million in 2012 to CHF 3.4 million in 2013, which represents an increase of 5.6 %. For SMIM companies, the average base salary increased by 14.2 % from 2012 to 2013 and has now essentially returned to the level of 2007 (CHF 1.2 million). The average cash bonus also increased from CHF 746,366 in 2012 to CHF 935,730 in 2013 which equals %. Similarly, average long-term incentives increased from CHF 826,547 in 2012 to CHF 1.1 million in 2013 (+27.3 %). Thus, the long-term incentive portion increased in 2013, while the portion of base salary as well as the cash bonus decreased slightly. Overall, the level of total variable compensation increased by 24.1 % to CHF 2 million when comparing 2012 to Figure 10: Structure of average total compensation of CEOs in SMIM companies % % Million CHF % 10% 26% 13% 29% 9% 29% 12% 35% 11% 29% 32% % 20% 20% 25% 23% 26% 26% % 44% 38% 37% 30% 34% 31% Base salary Cash bonus Long-term incentives Other payments PwC Executive Compensation & Corporate Governance 13

16 3.5 Wealth changes due to share ownership In addition to analysing the total compensation development, it is also important to understand net wealth changes in the share ownership of board members and executives resulting from share price changes. These can be substantial in the case of volatile markets. Table 1 lists these changes and developments. The highest gains and losses relate to chairmen and other board members who have significant share holdings (in particular as founders or founding family members). In 2008, at least 75 % of CEOs, chairmen and other board members suffered net wealth losses resulting from falling share prices. In 2009, we observed the mirror image, i.e., at least 75 % of the persons surveyed benefited from rising share prices. In 2010, an intermediate result occurred. The median CHF wealth change due to ownership was around zero or slightly positive for all three groups. The difficult market environment in 2011 led to broad losses throughout, and so the gains the median CEO, chairman and board member had made in 2009 and 2010 essentially evaporated in In 2012 the significant positive market development helped the median CEO recoup all losses from the previous year so that the overall wealth position of this (imaginary) median CEO was, at the end of 2012, approximately the same as at the beginning of In line with the stock market development, the year 2013 brought continued positive wealth changes for all three groups of individuals (at least for 75 % as in the year 2009). For example, the median CEO s wealth in equity in his company increased by CHF +1,250,000. The wealth changes of the middle half of CEOs, chairmen, and other board members are in a relatively narrow range around the median. 50 % of all CEOs (between the lower and upper quartile) experienced wealth changes in the amount of CHF +540,000 to CHF +2,150,000. For chairmen, this range is from CHF +180,000 to CHF +1,450,000 for For other board members, this range amounts to CHF +30,000 to CHF +400,000 for We discuss shareholdings more generally in Section Executive Compensation & Corporate Governance PwC

17 Table 1: CEO and board of director wealth changes in SMI and SMIM companies in the years 2008, 2009, 2010, 2011, 2012 and 2013 due to ownership 7) 2008 Highest gain Top 25 % (upper quartile) Median Bottom 25 % (lower quartile) Greatest loss CEOs +42,800, , ,000 2,880,000 2,750,000,000 Chairmen +190, ,000 1,820,000 18,700, ,000,000 Other Members of the Board of Directors +42,800,000 40, , ,000 3,010,000, Highest gain Top 25 % (upper quartile) Median Bottom 25 % (lower quartile) Greatest loss CEOs +10,300, , , ,000 35,400,000 Chairmen +2,170,000,000 +5,810, , ,000 30,100,000 Other Members of the Board of Directors +1,440,000, , ,000 +/ 0 23,000, Highest gain Top 25 % (upper quartile) Median Bottom 25 % (lower quartile) Greatest loss CEOs +20,000, , ,000 80,000 21,100,000 Chairmen +1,899,000, , ,000 80,000 32,100,000 Other Members of the Board of Directors +713,000, , ,000 30, ,000, Highest gain Top 25 % (upper quartile) Median Bottom 25 % (lower quartile) Greatest loss CEOs +10,600, , ,000 1,060,000 99,300,000 Chairmen +10,600, , ,000 1,290,000 70,800,000 Other Members of the Board of Directors +44,400,000 10,000 70, ,000 1,570,000, Highest gain Top 25 % (upper quartile) Median Bottom 25 % (lower quartile) Greatest loss CEOs +59,300,000 +1,350, , ,000 10,200,000 Chairmen +519,000, , , , ,000 Other Members of the Board of Directors +1,100,000, , , , ,000, Highest gain Top 25 % (upper quartile) Median Bottom 25 % (lower quartile) Greatest loss CEOs +168,000,000 +2,150,000 +1,250, ,000 1,730,000 Chairmen +71,400,000 +1,450, , , ,000 Other Members of the Board of Directors +455,000, , , ,000 61,900,000 7) All amounts in CHF and rounded. Wealth changes in 2008 are calculated as the difference between the wealth due to the average of the reported shareholdings on 31 December 2007 and those on 31 December 2008, valued on 31 December 2008, minus the value of these average shareholdings on 31 December For wealth changes in 2009, 2010, 2011, 2012, and 2013 the same methodology is applied. All shares (not only vested shares) are considered. Companies that report no shareholdings for the respective category of individuals are not considered in this table. Significant changes in wealth in these calculations can also arise, independent from developments in the share price, when an individual acquires or sells shares. Outside (non-equity) wealth is not observable. All the numbers reported in this section do not reflect implied ownership through options or other instruments similar to equity. They are merely based on what companies report to be the direct alignment of their CEOs with shareholders through the ownership of shares. PwC Executive Compensation & Corporate Governance 15

18 3.6 Small-cap companies Like last year, we have also examined compensation of executives and board members in a wider sample. In particular, we also consider those companies that ranked 51st to 100th in terms of equity market capitalisation at the end of the year Essentially, our study covers those 50 companies in the SPI Large and SPI Mid indices (which together contain 100 companies) that are not in the SMI and the SMIM. We refer to these companies in total as small-cap companies. Naturally, this large sample provides a wealth of data. We highlight some salient, general facts here. More detailed evaluations, geared to the interests of the reader, are available on request. The median board member at a small-cap company receives pay of around CHF 110,000, and this pay level has remained essentially stable in the past seven years. The median CEO of a small-cap company received CHF 1.2 million in As such, median CEO pay has increased by 5.1 % from 2012 to 2013, putting it slightly above 2007 levels. The range of the middle 50 % of small-cap total CEO compensation has increased quite substantially in the past year and is now between around CHF 920,000 (+11 %) and CHF 1.9 million (+25.5 %). This corresponds approximately to the range of the middle 50 % of base salary for SMI CEOs. Total compensation of small-cap CEOs is less volatile over time than is pay of SMIM CEOs (which is, as we have seen earlier, more stable than pay of SMI CEOs). We return to the pay differences according to company size in our discussion of pay for performance below. Figure 11: Total compensation of CEOs in small-cap companies 8) Million CHF Lowest Lower quartile Median Upper quartile Highest 8) n=47 in One company, which belongs to the SPI Large index but is not part of SMI nor the SMIM indices, is not included in this study as we consider it to be unrepresentative of the sample we wish to study. 16 Executive Compensation & Corporate Governance PwC

19 Rewards in the form of equity participation are of relatively minor importance for CEOs in small-cap firms. The fraction of incentives paid in the form of equity remained similar in 2013 to 2012, with on average just 11 % of total compensation of small- cap firm CEOs being equity-based incentives. For CEOs in small-cap firms, the portion of base salary in total compensation has conversely increased from around 40 % in 2007 to around 50 % in Finally, we have also analysed the wealth changes due to share ownership of executives and board members in small-cap firms. Table 2 presents the results of this investigation of equity wealth changes. It is more difficult than in the case of the SMI and SMIM companies to compare amounts across years because the composition of the sample has changed more for the small-cap firms. Nonetheless, by and large the table shows that, over the years, the median small-cap executives and board members have experienced much the same fluctuations as their colleagues in the larger firms. Table 2: Median CEO and board of director wealth changes in small-cap companies in the years 2008, 2009, 2010, 2011, 2012, and 2013 due to ownership 9) CEOs Chairmen Other members of board of directors , ,000 40, , , , , , , ,000 80,000 20, , , , , , ,000 Figure 12: Total compensation of other members of the board of directors in small-cap companies 10) Million CHF Lowest Lower quartile Median Upper quartile Highest 9) For details on the calculation, see footnote 7. 10) n=304 in 2013 PwC Executive Compensation & Corporate Governance 17

20 4 Executive Compensation and Corporate Governance after the Abzocker-Initiative : Challenges and Opportunities The general perception in society, but also among many shareholders, is that executive compensation is not sufficiently tied to performance. Indeed, some cases come to mind where the pay-performance relationship was arguably tenuous at best. This perception was one of the reasons for the adoption of the Abzocker-Initiative, with broad ramifications for the governance of Swiss companies. Shareholders are paying increasing attention to the alignment of pay with performance. In this chapter in section 4.1, we first consider whether empirically a pay-performance relationship exists in Swiss listed companies. This analysis provides both a policy-relevant input and an input for discussions on the company level. It also prompts several important questions regarding the design of compensation plans, to which we turn in section 4.2. In many ways, the design of compensation plans is closely linked to their governance, which we study in section 4.3. To complement our conceptual discussion of challenges for the board of directors in compensation governance, we provide some data on how companies have responded in the revision of their articles of association. 4.1 Pay for performance There are several distinct components linking pay and performance which boards of directors and, in particular, members of compensation committees, need to be aware of and which they can use. Table 3 presents an overview of five perspectives of pay for performance. We discuss each point in turn. Table 3: Five perspectives on pay for performance Channel Firm-wide profits and top management pay Direct pay for performance: Change in variable CEO compensation when performance changes Increase in TSR by 1 percentage point Increase in ROA by 1 percentage point Increase in ROE by 1 percentage point Career concerns inside the firm: CEO total pay as a multiple of non-ceo executive total pay (median value) Career concerns across firms: median total pay of the CEO CEO equity wealth change per CHF 1,000 shareholder wealth change Observation The ratio of executive total compensation to EBITDA is approximately constant over time Change in variable CEO compensation (all companies, controlling for firm characteristics) +1.2 % n.s. +5 % SMI: 3 times SMIM: 2 times Small-cap: 2 times SMI: CHF 6.7m SMIM: CHF 3.2m Small-cap: CHF 1.2m SMI: CHF 0.2 SMIM: CHF 0.6 Small-cap: CHF 1 18 Executive Compensation & Corporate Governance PwC

21 Figure 13: Total executive compensation as a fraction of EBITDA in SMI, SMIM, and small-cap companies 6% 5% 4% 3% 2% 1% 0% Lower quartile Median Upper quartile The general link between profits and compensation 2013 A concern sometimes raised is that executive compensation does not vary sufficiently with the underlying economic performance of a company. To shed some initial light on this question, in Figure 13, we plot the ratio of total executive board and total board compensation as a fraction of EBITDA. The sample consists of all the companies in our study. Two interesting observations emerge. First, there are large differences among firms in the percentage of profits that accrue to executive compensation. In the lower quartile, around 1 % of EBITDA is paid out to executive management, whereas in the top quartile more than 4 % is paid out to executive management. Note that these numbers refer to the full sample. There are, of course, differences among companies in terms of size. In the SMI firms, the median executive compensation to EBITDA ratio is around 0.7 %; in SMIM firms, the median is around 1.9 %, in small-cap companies, the median is around 3 %. The relative numbers across quartiles are, however, fairly similar in these three groups of companies. Second, from the perspective of pay for performance, it is noteworthy that the fraction of earnings going to top executive management has been fairly stable over recent years on average. In other words, when profits go up, compensation tends to go up, and when profits go down, compensation tends to go down. However, when looking closely, there appears to be some trend towards top earners among executive management (the top quartile of the ratio of executive compensation to EBITDA) receiving an increasing fraction of EBITDA. Even at the median, there is a slight upward trend. Boards should be aware of the percentage of profits used for top management compensation. An issue that is difficult to navigate in practice but that tends to draw the attention of shareholders is how extraordinary events should be taken into account. Should these be treated as exogenous events that should be filtered out? Or should management be held accountable for appropriately responding to such events, too? We discuss this question in some more detail in Section below but emphasise here that transparent, consistent communication is key in this matter. PwC Executive Compensation & Corporate Governance 19

22 4.1.2 CEO variable pay and performance Second, drilling deeper from the aggregate level we can now ask: On the individual CEO level, what is the relationship between performance in a year and pay received for that year? Determining the direct relationship of CEO pay and performance is a challenging task. First, total CEO pay has both backward-looking and forward-looking components, and as such is not a direct indication of what the CEO received for his actual performance. We use CEO variable compensation (short-term incentives and long-term incentives) as disclosed by companies as the quantity of interest. We do note, however, that companies do not always separate pay that is awarded for past performance from pay that is received as an incentive for future performance (where the latter may correctly be independent of past performance). Second, there are several factors that are associated with both pay and performance. Therefore, if one were to simply calculate a correlation of pay and performance, such a correlation may pick up omitted factors. To address this issue, we conduct a regression analysis. Thus, we make firms comparable by taking into account the size of the firm, the risk of the firm, and other factors. The analysis also takes out any common time trends. 11 The main result of this analysis is that there is a statistically significant relationship between variable pay (the dependent variable) and some, but not all performance measures. However, the economic significance of the association may be considered small. A one percentage point increase in total shareholder return (TSR) (say, from 6 % to 7 %) in a given year is associated with an increase in CEO variable pay, for that year, of about 1.2 %. An alternative way to understand the economic meaning of these numbers is to think in terms of standard deviations. The data imply that a one standard deviation increase in TSR is associated with a one tenth of a standard deviation increase in variable pay, a fairly modest impact. Similarly, variable pay is also statistically significantly associated with return on equity (ROE), but economically the relationship is not very strong, with a standard deviation increase in ROE being associated with a one eighth of a standard deviation increase in variable pay. 11) However, some factors are difficult to control for. For example, as mentioned in the descriptive analysis, CEO changes can lead to higher compensation, particularly when a CEO is appointed from the outside. At the same time, an involuntary CEO change is more likely if performance has been poor. This would tend to bias the results against finding a significant relationship between pay and performance. Interestingly, and perhaps somewhat worryingly, the data does not provide evidence of a statistically significant relationship between operating performance, as measured by return on assets, ROA, and variable pay. There is, however, a strong relationship between ROA and total CEO pay, consistent with the idea that more profitable firms in general pay higher compensation. Overall, boards of directors need to consider whether pay in their company is designed to foster long-term value generation. We discuss some design challenges that we have encountered in practice below Pay differences within companies: Tournament incentives A third aspect of incentives and opportunities to reward performance with pay derives from tournament incentives inside the firm. By this we mean the observation that climbing the corporate ladder typically entails increases in pay, which creates incentives for management to work hard and secure a promotion. To measure this source of incentives, we calculate CEO pay as a multiple of the average compensation of non-ceo executives. Table 3 reports the median value of this multiple. A promotion to CEO from being a non-ceo executive member implies, at the median, a doubling or tripling of the total pay package, suggesting strong monetary incentives to attain the top position. As expected, this multiple is significantly higher in SMI firms than in SMIM firms. This result is consistent with the idea that there is a premium for managing larger, more complex companies. These numbers have to be interpreted with care. For example, the experience as well as the roles and responsibilities of executives vary significantly. Naturally, individual performance also plays an important role. Companies may have different policies in terms of which group of top management they disclose in the remuneration report. Finally, we also note that there can be drawbacks when pay distribution is too unequal. When the CEO receives a much larger pay package than other executives (adjusting for experience and other factors), this can indicate an imbalance of power and a culture that is not conducive to productive discussions, leading to excessive conflicts and potential governance problems. 20 Executive Compensation & Corporate Governance PwC

23 4.1.4 Pay differences among companies: Implicit incentives due to the labour market As Table 3 shows, the median CEO of an SMI company earns twice the total compensation that the median CEO of an SMIM company earns. And the median CEO of an SMIM company receives 2.6 times the total compensation that a small-cap CEO obtains. Similar ratios also hold for average compensation. Given this strong relationship between top management pay and firm size, and given the powerful empirical relationship between management performance and career advances, we conclude that there can be substantial implicit incentives through career concerns for executives of Swiss companies. That is, these individuals are motivated not only by the incentive system in place in their current job, but they also arguably take into account that good performance now opens up better career opportunities in particular, the opportunity to manage a larger, higher-paying firm in the future. Conversely, they are aware that poor performance now is likely to result in fewer such opportunities in the future; indeed, poor managers may find themselves slipping down a notch or two in the size of the company they lead, which implies lower pay. When added up over the duration of a career, these forward-looking incentives can be substantial Wealth incentives In 2013 the median CEO equity ownership in SMI companies was 0.02 %, while it corresponds to 0.06 % in SMIM firms. This means that a CHF 1,000 change in shareholder wealth in a given year corresponds to a CHF 0.20 and a CHF 0.60 CEO wealth change, respectively. In the SMI and SMIM firms, the median CEO holds roughly CHF 4.0 million in equity, which is around three-and-a-half times the CEO s annual base salary. This is up from two times the base salary at the beginning of the sample period. The percentage wealth change, defined as the wealth change of a disclosed person expressed as a percentage of the wealth he holds in shares of his company, can be substantial also in Switzerland: the median percentage wealth change of SMI and SMIM CEOs was +33 % from 2012 to For chairmen this number was %, for other board members it was %. CEO participation in small-cap firms is more widespread and reaches higher total levels in terms of fractions of ownership than in the SMI and SMIM companies. For example, in 2013 the median CEO equity ownership in small-cap companies is 0.1 %. This means that a CHF 1,000 change in shareholder wealth in a given year corresponds to a CHF 1.00 change in CEO wealth. However, naturally, the median CEO of an SMIM company holds about twice the amount of wealth in firm s equity than the median CEO of a small-cap company. Overall, despite some fluctuations over the years, we are witnessing an increase in the wealth lever. This occurs both on the extensive and the intensive margins: First, more CEOs are holding equity and the proportion of CEOs who do not hold any shares has dropped sharply in the past seven years. Second, those who already hold equity hold large positions (and/or do not sell the shares even though share prices have increased). 4.2 Challenges in the design of compensation systems Based on the above analysis, and based on our experience in advising companies, several challenges arise in the design of compensation. Here, we discuss a selection of three interlinked key questions. First, what are useful key performance indicators that can be used as a basis for determining compensation? Second, should only relative performance be rewarded? Third, should there be caps on variable pay? What are useful key performance indicators? A compensation system should be designed to incentivise individuals appropriately, to attract those who match the company s needs, and to retain the best-suited employees. As regards the design of incentives, a question that often arises is which indicators of performance should be used. Three aspects play a role here, and as we will see, it is important to recognise that the question of incentives cannot be considered separately from the issues of attraction and retention. First, a compensation system should ensure alignment of managerial actions with firm value. Second, incentives are most effective when they relate to something that the manager can actually control. Third, teamwork is essential in today s environment, and so the interdependence of managers actions needs to be reflected in the compensation system. PwC Executive Compensation & Corporate Governance 21

24 While these three goals arguably make sense taken individually, the crux of incentive design is that goals are often in conflict with each other. The key idea to realise is that firms get what they pay for. Thus, when banks reward employees for attracting net new money, they will attain higher net new money flows, but possibly at the cost of attracting bad money. When a salesforce is rewarded for higher customer satisfaction, they will achieve higher customer satisfaction, but possibly by giving special favours to customers that may be unsustainable in the long run. And when managers are rewarded for increasing accounting profits, they will indeed increase accounting profits, but possibly do so by engaging in (legal) accounting earnings management or foregoing profitable investment opportunities (thus conducting real earnings management), which in the long run hurts firm value. More generally speaking, broad key performance indicators such as firm-wide economic profit or even just the stock price optimally ensure aligment of managerial incentives with the interests of the firm and such also provide incentives for cooperation among managers. However, these indicators provide for poorer line of sight, and they offer a cruder measure of individual performance. On the other hand, specific individual performance measures provide exact measures of individual achievement and offer managers a clear, controllable line of sight, but they may lead to distorted behaviour and only provide for limited teamwork incentives. In sum, there is no panacea and no unique answer to the question of what is an appropriate set of key performance indicators. What can be said (and cannot be emphasised enough), however, is that an effective compensation system has to be designed as as a best fit with company strategy, that is, it needs to be tied to the specific value drivers of a company, and it should be communicated as such Should only relative performance be rewarded? When choosing key performance indicators, an issue of great practical importance is whether absolute or relative performance should be rewarded. Some observers are concerned that executive pay for performance may still at least partially be pay for good luck or bad luck (that is, performance aspects outside the control of the CEO). Conceptual considerations and our practical experience suggest a differentiated view should be taken on this matter. On the one hand, traditional agency theory argues that the principal should filter out all observable exogenous shocks when linking pay and performance. This idea of indexing compensation fits well with the intuitively appealing notion that managers should not be rewarded merely for good luck that comes, for example, from generally rising share prices or favourable market conditions. On the other hand, even if performance was good relative to, say, the industry, firm-specific performance on an absolute basis may still have been quite bad. Shareholders in general do not care about relative performance but rather about absolute performance. (Notably, however, asset managers who are frequently paid based on relative performance and pension funds may directly care about relative total shareholder return.) Moreover, relative performance evaluation tends to increase and possibly distort risk-taking incentives when management realises that it is below the competition. Furthermore, and critically, indexing limits even destroys another important function of compensation: retention. In particular, one central advantage of non-indexed equity-based compensation is that it should increase in value as the general stock market rises. Thus, together with suitable vesting and service conditions, managers who hold equity are less likely to leave. Next, the question quickly arises as to which index (the peer group ) to use, and whether and how to disclose the index and index changes. Several studies suggest that severe agency conflicts can arise when management itself is involved in choosing a suitable peer group. Finally, when aspects that a manager cannot control are part of a compensation system, management is thus encouraged to proactively consider how it responds to challenges in the external environment. 12 Overall, these considerations suggest that an incentive system should in general not only be based on relative performance. Non-indexed equity-based or equity-related pay is an important compensation component. 12) Consequently, Murphy and Jensen (2011), CEO bonus plans: And how to fix them, Harvard Business School Working Paper, Boston, p. 42, argue that executives should be held accountable for factors that are out of their control when they can control or affect the impact of these non-controllable factors on performance. 22 Executive Compensation & Corporate Governance PwC